The Dow Jones Industrials (DJINDICES:^DJI) have been hitting new all-time records for months. With every new Dow milestone that goes into the books, more investors start getting nervous about how to protect themselves against what many see as an inevitable downturn.
Obviously, one solution is simply to sell off your stocks. Yet doing so means giving up every penny of potential future gains, as well as incurring capital-gains tax liability. Instead, one alternative strategy to consider involves buying put options. Although many investors see options as being too risky, buying puts as part of your broader portfolio strategy can actually reduce risk compared to simply owning stock outright.
Crash protection -- at a price
Put options give you the right to sell stock at a particular price within a certain period of time. If the share price falls below the option's specified strike price, then it'll be smart for you to exercise your option to get an above-market price for your shares. But if the share price stays above the put option strike price, then you won't exercise and will simply allow the option to expire unused.
Investors interested specifically in the Dow have a couple of choices. First, if you invest in the Dow using the SPDR Dow Jones Industrials ETF (NYSEMKT:DIA), then you can buy put options on ETF shares in 100-share increments. Alternatively, CBOE Holdings (NASDAQ:CBOE) came out with Dow options that are tied to the index rather than to specific shares of stocks or ETFs, with the index value equal to 1% of the Dow's value.
In either case, though, the idea is the same: pick the price level at which you want crash protection to kick in, and choose the timeframe during which you want protection. Those two variables will determine how much you'll have to pay for the put option.
Obviously, the longer you want protection, the more you'll have to pay. For instance, put options at a level roughly 5% below where the Dow ETF trades currently that expire in mid-October will cost you $1.34 per share. But the same option that extends through mid-December will cost you more than twice as much, at $2.78 per share.
The put-option trade-off
The problem with buying crash protection is that the cost eats away at your total returns. Right now, volatility levels as measured by the S&P Volatility Index (VOLATILITYINDICES:^VIX) are relatively low, so crash protection is actually pretty cheap compared to more normal market conditions. Nevertheless, if stocks go up, stay flat, or even fall less dramatically than where your put options protection kicks in, then you'll lose what you paid for the option. You can't afford to suffer repeated losses without severely damaging your portfolio performance.
Still, if you have very specific worries about the market and are comfortable taking a stand on exactly when a crash or correction might happen, then put options can help you reduce or eliminate losses without having to sell your shares. The fact that you still get to reap rewards if the Dow keeps rising is just icing on the cake.
Fool contributor Dan Caplinger has no position in any stocks mentioned. You can follow him on Twitter: @DanCaplinger. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.